Futures brokers are facing difficult times amid stormy market conditions that have already forced some firms into radical action.

These firms – also known as futures commission merchants – provide execution and clearing services, including direct market access and credit, to hedge funds and proprietary trading firms that wish to trade on the futures markets but which are not big enough to be a member of a market or its clearing house.

The industry has been buffeted by a combination of the rise in electronic trading, which has reduced the commissions a broker can charge for execution services; vanishing income from investments; and declining derivatives trading volumes, which fell 10.2% globally for the first six months of last year compared with the same period in 2011, according to the Futures Industry Association.

Industry experts say declining investment income has proved especially damaging. Fred Ponzo, managing partner at financial services consultancy GreySpark, said that, historically, many futures brokers charged clearing services at cost in order to attract large deposits from clients for money used in the clearing process. Clients must pay cash and securities to clearers, via their broker, as a surety against their positions.

Brokers can make money from this client cash by “pocketing the difference” between the interest rate they receive on the deposits and the rate they pass on to the client.

According to a study by US consultancy Tabb Group published last month, US FCMs collectively made more than 40% of their income in this way in 2008 – more than they made from either clearing or execution.

But with interest rates in the US and Europe at record lows, this source of revenue has all but dried up. Tabb Group said that, this year, investment income was expected to account for just 10% of US FCMs’ revenues and the pool of revenues available to US FCMs is set to almost halve from $7bn to $4bn.
As the available revenue has shrunk, so too has the number of brokers. A study by PA Consulting in September found that the number of US FCMs registered with the Commodity Futures Trading Commission had dropped by 33% since 2008. Kamal Mohindra, author of the PA Consulting study, said that the European FCM community has diminished by a similar amount. Tabb Group’s study believes that number in the US will fall a further 20% by the end of 2014 (see chart).

The industry has also seen two high-profile exits in the form of the bankruptcies of MF Global in October 2011 and Peregrine Financial last July.

Tabb Group’s analyst Matt Simon believes further consolidation in the futures brokerage market will be driven by the mandated shift of many over-the-counter derivatives towards electronic trading and clearing under Dodd-Frank in the US and the European Market Infrastructure Regulation.

Nearly two-thirds of the FCMs Tabb Group interviewed said they were hopeful that the new clearing requirements would boost futures trading volumes in 2013 as firms look for cheaper exchange-listed derivatives in place of more costly OTC products.

According to Tabb Group’s Simon, those with bigger budgets, particularly bank-owned FCMs, will embrace the shift but smaller players will struggle to keep up. He said: “We believe the current environment will prompt a further wave of consolidation, especially for middle-tier firms. A revenue shift will favour larger FCMs as market participants transition their OTC activity into existing futures and emerging swap futures products. Customers will want to clear their over-the-counter products with the same firms they use for clearing futures and will favour those existing relationships.”

He said this was going to make it difficult for smaller and mid-tier FCMs that did not have a consolidated OTC service offering to remain competitive.

Some have suggested that, when interest rates rise again, many FCMs could simply revert to a middle-of-the-road existence, living from the roughly even split of revenue they enjoyed in the past between investment, execution and clearing.

Several of the 15 US brokers polled by Tabb Group held this view. But, with base rates in the US and Europe not projected to rise significantly within the next two years, many firms will have to eke out an existence in a hostile environment of falling volumes, increased costs and structural changes in the system.

Steve Grob, head of strategy at securities technology vendor Fidessa, said firms which were relying on a potential pick-up in volumes to revive their current business model were “seriously misguided”. He said: “This is not a storm that’ll blow over; this is climate change. Even if rates rise in a couple of years’ time, those who haven’t adapted their business model in the meantime won’t be around to capitalise.”

Nicolas Breteau, chief executive of Newedge, one of the biggest futures brokerages which recently announced a major restructuring, agreed that the market dynamic had changed fundamentally. He said: “Recent events show that traditional market mechanisms don’t seem to apply any longer. Uncertainty once typically resulted in higher volatility, hence, higher trading volumes. However, despite massive amounts of uncertainty over the last six months, this did not translate into an uptick in volumes. Instead, many major market participants withdrew completely from trading.”

However, he said, there remain opportunities for futures brokerages to diversify their revenue streams, much as their cousins in the interdealer market have done. He said: “In such conditions, managing costs closely is obviously critical, but it is also an opportunity to diversify revenue streams and invest in future growth areas, such as OTC clearing or collateral management – both are on our agenda for 2013 – as well as implementing smarter, leaner and more effective infrastructure and IT solutions.”

• Adapting to the challenge: one brand, two structures

As Newedge maps out its future as two companies, many are asking whether its model may offer a blueprint to others. Last month, Newedge unveiled a radical restructuring programme to divide its execution and clearing businesses into separately capitalised entities.

The firm, which was formed when French banks Société Générale and Crédit Agricole merged their futures brokerages in 2008, is one of the largest global futures brokerages, employing 3,000 staff across more than 20 countries, according to its 2011 annual report. Despite its market dominance, however, the company has been up for sale for more than a year, according to media reports.

Nicolas Breteau, Newedge’s chief executive, told Financial News that the restructure would allow the group to reduce its overall capital burden – which will grow under new international capital rules – by pushing its execution business into a separate agency brokerage. Agency brokers take on less risk than banks and are, therefore, subject to lower capital requirements.

He said: “Within the new capital and liquidity requirements under Basel III, Emir and Dodd-Frank, separating these two business areas would enable us to allocate valuable resources, including capital, more effectively and set up supervisory structures that meet each business’s separate needs.”

He said the split also had advantages from a client service point of view. In future, the firm believes trading and clearing will become very different, highly specialised businesses, for which a one-size-fits-all approach is not appropriate.

Breteau said: “To us, delivering effective clearing and execution of financial futures and options solutions requires different approaches. Execution is all about agility, access and value added, while clearing is a commoditised service in a comparatively heavily regulated framework [where] scale is what matters most.”

Newedge’s approach differs markedly, however, from many of the firm’s bank-owned rivals, which have moved swiftly to create integrated execution and clearing “supermarkets” to cater to as many clients as possible.

These players do not share Newedge’s vision of the future. The global head of futures at one investment bank said: “The future doesn’t look great for execution-only brokers. This is a market which is already coming to be dominated by a few large-flow players, who can offer a full range of clearing and ancillary services to clients on a truly global basis.”